Managerial Accounting PDF

lOMoARcPSD|11350337 Managerial Accounting Financial statement analysis and managerial accounting (Università Cattolica del Sacro Cuore) Studocu is not sponsored or endorsed by any college or university Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement An...

lOMoARcPSD|11350337 Managerial Accounting Financial statement analysis and managerial accounting (Università Cattolica del Sacro Cuore) Studocu is not sponsored or endorsed by any college or university Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting | Martina Marazzi MANAGERIAL ACCOUNTING MANAGERIAL ACCOUNTING: AN OVERVIEW Managerial accounting is something different from financial accounting: the only thing that they have in common is the term accounting, that entails working with numbers, collecting data, organizing, and classifying data, and so on. As regards to managerial accounting, the audience is the management, from the top management up to the operating one: so, we’re talking about quantitative information that are used at all levels of the organization (internal audience). If managerial accounting addresses the management with this information, the management will not need detailed information, but just aggregate measures of the company. The scope of this subject broadens very much, and differently from financial accounting, for which there were principles to organize the information, in managerial accounting we have free formats (basically there’s no accounting principles). However, the fact that there are more or less correct doesn’t mean that there are practices that are more or less correct, so instead of having principles institutionalized by an accountancy body, there are methodologies that are suggested by best practices. With regards to managerial accounting, we do have both historical, past data, but also forward-looking data, while in financial accounting we were just looking about the past. If this data has to exert an influence, of course it will exert an influence on the audience that is addressed, so internally for managerial accounting and externally for financial accounting. FINANCIAL AND MANAGERIAL ACCOUNTING: SEVEN KEY DIFFERENCES FINANCIAL ACCOUNTING External persons who make financial decisions Historical perspective Emphasis on objectivity and verifiability MANAGERIAL ACCOUNTING Managers who plan for and control an organization Future emphasis Emphasis on relevance Emphasis on precisions Emphasis on timeliness Primary focus is on companywide reports Must follow GAAP/IFRS and prescribed formats Mandatory for external reports Focus on segment reports Not bound by GAAP/IFRS or any prescribed format Not mandatory USERS TIME FOCUS VERIFIABILITY VERSUS RELEVANCE PRECISION VERSUS TIMELINESS SUBJECT RULES REQUIREMENTS WORK OF MANAGEMENT If we have to produce data that are meaningful for the managerial activity, we have to know which is the managerial activity implied: – – Planning: identifying a target (an objective) • Establish Goals • Specify How Goals Will Be Achieved • Develop Budgets Controlling: the control function gathers feedback to ensure that plans are being followed • – Feedback in the form of performance reports that compare actual results with the budget are an essential part of the control function Decision making: decision making involves making a selection among competing alternatives • What should we be selling? • Who should we be serving? • How should we execute? PLANNING – Marketing majors 1 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting | Martina Marazzi – – • How much should we budget for TV, print, and internet advertising? • How many salespeople should we plan to hire to serve a new territory? Supply Chain Management Majors • How many units should we plan to produce next period? • How much should we budget for next period’s utility expense? Human Resource Management Majors • How much should we plan to spend for occupational safety training? • How much should we plan to spend on employee recruitment advertising? CONTROLLING – – – Marketing majors • Is the budgeted price cut increasing unit sales as expected? • Are we accumulating too much inventory during the holiday shopping season? Supply Chain Management Majors • Did we spend more or less than expected for the units we actually produced? • Are we achieving our goal of reducing the number of defective units produced? Human Resource Management Majors • Is our employee retention rate exceeding our goals? • Are we meeting our goal of completing timely performance appraisals? DECISION MAKING – – – Marketing majors • Should we sell our services as one bundle or sell them separately? • Should we sell directly to customers or use a distributor? Supply Chain Management Majors • Should we transfer production of a component part to an overseas supplier? • Should we redesign our manufacturing process to lower inventory levels? Human Resource Management Majors • Should we hire an on-site medical staff to lower our healthcare costs? • Should we hire temporary workers or full-time employees? ACCOUNTING MAJORS The IMA estimates that more than 80% of professional accountants in the U.S. work in non-public accounting environments. Employers expect accounting majors to have strong financial accounting skills, but they also expect application of the planning, controlling, and decision making skills that are the foundation of managerial accounting. CERTIFIED MANAGEMENT ACCOUNTANT (CMA) To become a CMA requires membership in the Institute of Management Accountants, a bachelor’s degree from an accredited college, two continuous years of relevant professional experience, and passage of the CMA exam. CMA EXAM CONTENT SPECIFICATIONS Part 1 Financial Reporting, Planning, Performance, and Control External financial reporting decisions Planning, budgeting, and forecasting Performance management Cost management Internal controls Part 2 Financial Decision Making Financial statement analysis Corporate finance 2 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting | Martina Marazzi Decision analysis Risk management Investment decisions Professional ethics CHARTERED GLOBAL MANAGEMENT ACCOUNTANT (CGMA) The CGMA designation is co-sponsored by the American Institute of Certified Public Accountants (AICPA) and the Chartered Institute of Management Accountants (CIMA). One pathway to the CGMA requires a bachelor’s degree in accounting (accompanied by a total of 150 college credit-hours), passage of the Certified Public Accountant (CPA) exam, membership in the AICPA, three years of relevant management accounting work experience, and passage of the CGMA exam— which is a case-based exam that focuses on technical skills, business skills, leadership skills, people skills, and ethics, integrity, and professionalism. MANAGERIAL ACCOUNTING: PLANNING, CONTROLLING, AND DECISION MAKING The primary purpose of this course is to teach measurement skills that managers use to support planning, controlling, and decision-making activities. MANAGERIAL ACCOUNTING AND COST CONCEPTS 3 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting | Martina Marazzi NEEDS OF MANAGEMENT – – Financial accounting is concerned with reporting financial information to external parties, such as stockholders, creditors, and regulators. Managerial accounting is concerned with providing information to managers within an organization so that they can formulate plans, control operations, and make decisions. COST CLASSIFICATION Purposes of Cost Classification 1. 2. 3. 4. 5. Assigning costs to cost objects Accounting for costs in manufacturing companies Preparing financial statements Predicting cost behavior in response to changes in activity Making decisions “Different costs for different purposes”: there is not one cost that is right and one that is wrong, but the essence of this slogan is to identify the costs that are relevant for the purpose of the analysis. Managerial accounting is all about running analysis, and for each purpose we need to frame a different type of information. Learning Objective 1: Assigning costs to cost objects: direct costs and indirect costs DIRECT COSTS Costs that can be easily and conveniently traced to a unit of product or other cost object – Examples: direct material and direct labor INDIRECT COSTS Costs that cannot be easily and conveniently traced to a unit of product or other cost object (therefore, if we want to assign this indirect cost to the cost object, we must implement particular criteria) – Example: manufacturing overhead Whether the cost is direct or indirect depends on how we define the cost object. The direct versus indirect cost is not a constant classification, but it depends on how we define the cost object. Therefore, first you have to say what is the cost object, and then with reference to the specific cost object I can tell whether the cost is direct or indirect. The fact that costs are indirect, originates the phenomenon of common costs (for example the cost of shared personnel). Common costs are costs incurred to support a number of cost objects; these costs are not directly associated to the product and cannot be traced to any individual cost object. Learning Objective 2: Classifications of Manufacturing Costs We are so concerned about manufacturing costs because cost accounting is very relevant anywhere, but it started in the manufacturing environment. If you think about 30/40/50 years ago, most companies were manufacturing ones, and the question they all had was “how much does this product that we are manufacturing cost?” They defined the single product as the cost object. The manufacturing costs associated to the product (cost object) are: – Direct Materials • Direct materials are raw materials that become an integral part of the product and that can be conveniently traced directly to it – • Example: a radio installed in an automobile Direct Labor • Direct labor costs are those labor costs that can be easily traced to individual units of product – • Example: Wages paid to automobile assembly workers Manufacturing Overhead • Manufacturing overhead includes all manufacturing costs except direct material and direct labor. • These costs cannot be readily traced to finished products → Includes indirect materials that cannot be easily or conveniently traced to specific units of product 4 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting | Martina Marazzi → Includes indirect labor costs that cannot be easily or conveniently traced to specific units of product • Examples: Depreciation of manufacturing equipment, Utility costs, Property taxes, Insurance premiums incurred to operate a manufacturing facility • Only those indirect costs associated with operating the factory are included in manufacturing overhead However, there are also non-manufacturing costs. Therefore, there is a first classification between direct or indirect cost, and then a second classification between manufacturing or non-manufacturing costs. There are two types of non-manufacturing costs: • • Selling costs: costs necessary to secure the order and deliver the product. Selling costs can be either direct or indirect costs Administrative costs: all executive, organizational, and clerical costs. Administrative costs can be either direct or indirect costs Learning Objective 3: Cost classifications used to prepare financial statements: product costs and period costs To prepare financial statements, what is relevant is the distinction between product costs and period costs. Product costs include all costs that are involved in acquiring or making a product; therefore, they include direct materials, direct labor, and manufacturing overhead. They are costs that when you prepare the financial statements, and mainly the income statement and the balance sheet, will be included in the evaluation of cost of goods sold and inventory. Product costs attach to a unit of product as it is purchased or manufactured, and they stay attached to each unit of product as long as it remains in inventory awaiting sale. Basically, you cost a product and you decide which are the product costs: if the product is sold, this cost per unit will go to cost of goods sold; if the product is not sold, the cost per unit will be included into the inventory cost. For manufacturing companies, product costs include:    Raw materials: includes any materials that go into the final product Work in process: consists of units of product that are only partially complete and will require further work before they are ready for sale to the customer Finished goods costs: consists of completed units of product that have not yet been sold to customers Transfer of product costs: 1. When direct materials are used in production, their costs are transferred from raw materials to work in process 2. Direct labor and manufacturing overhead costs are added to work in process to convert direct materials into finished goods 3. Once units of product are completed, their costs are transferred from work in process to finished goods 4. When a manufacturer sells its finished goods to customers, the costs are transferred from finished goods to cost of goods sold Period costs are all the other costs, and they include all selling and administrative costs. They will inevitably be assigned to the period when the cost is incurred. What is the difference between the two? The difference is that anything that you define as product cost, has two options to show up: one in the income statement through the cost of goods sold, and the other one in the balance sheet as cost of the inventory. On the other hand, the period cost has only one way to show up, and that is in the P/L account. Quick Check Which of the following costs would be considered a period rather than a product cost in a manufacturing company? A. Manufacturing equipment depreciation (product cost) B. Property taxes on corporate headquarters C. Direct materials costs (product cost) 5 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting | Martina Marazzi D. Electrical costs to light the production facility (product cost) E. Sales commissions Learning Objective 4: Cost classifications for predicting cost behavior: variable costs, fixed costs, and mixed costs Cost behavior refers to how a cost will react to changes in the level of activity, and it is essential to do that since we are interests in seeing how the cost structure will react to changes in the volume of activity. The most common classifications are: – – – Variable costs • A cost that varies, in total, in direct proportion to changes in the level of activity • A variable cost per unit is constant, even though it changes as the volume of activity changes E.g. Raw materials Fixed costs • A cost that remains constant, in total, regardless of changes in the level of the activity • If expressed on a per unit basis, the average fixed cost per unit varies inversely with change in activity • Two types of fixed costs: COMMITTED Long-term, cannot be significantly reduced in the short term Mixed costs DISCRETIONARY May be altered in the short-term by current managerial decisions Learning Objective 5: Cost classifications for decision making: relevant costs and irrelevant costs This topic is very interesting to observe and very peaky to implement since relevant vs. relevant depends on the decision-making setting, so costs are not born relevant or irrelevant, but it depends on how the company frames its analysis. Decisions involve choosing between alternatives. The goal of making decisions is to identify those costs that are either relevant or irrelevant to the decision. To make decisions, it is essential to have a grasp on the concepts of differential costs and revenues, opportunity costs, and sunk costs. – – – Differential Costs • Differential costs (or incremental costs) are the difference in cost between any two alternatives (basically, it means looking for the costs that change between the two alternatives) • A difference in revenue between two alternatives is called differential revenue • Both are always relevant to decisions • Differential costs can be either fixed or variable Opportunity Cost • The potential benefit that is given up when one alternative is selected over another (it means that, by selecting activity A instead of activity B, you give up the benefit associated with B) • These costs are not usually found in accounting records but must be explicitly considered in every decision, so for managerial accounting purposes it is very important to detect those costs as well in order to make decisions Sunk Costs • Sunk costs have already been incurred and cannot be changed now or in the future • These costs should be ignored when making decisions Learning Objective 6: Prepare Income Statements for a merchandising company using the traditional and contribution formats 6 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting | Martina Marazzi We want to deal with managerial accounting because we want to prepare Income Statements using the so-called cost Behavior Income Statement, so Contribution Margin Income Statement. Depending on how costs are classified, there may be Income Statements by nature of the costs, by function or by cost behaviour, even if it is not very frequent that companies disclose their Income Statement by cost behavior for external reporting purposes, but for internal reporting purposes or for managerial purposes it is very frequent. The Traditional and Contribution Formats The traditional format is more for external reporting purposes, whereas the contribution format is used primarily for managerial purposes. However, we may even end up with an Income Statement that uses simultaneously the two classification criteria. Uses of the Contribution Format The Contribution Income Statement format is used as an internal planning and decision-making tool. We will use this approach for: 1. 2. 3. 4. Cost-volume-profit analysis (Chapter 2) Segmented reporting of profit data (Chapter 4) Special decisions such as pricing and make-or-buy analysis (Chapter 6) Budgeting (Chapter 8) COST-VOLUME-PROFIT RELATIONSHIPS Learning Objective 1: Explain how changes in activity affect contribution margin and net operating income 7 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting | Martina Marazzi APPLICATIONS OF THE COST-VOLUME-PROFIT ANALYSIS Costs classification can be used for different informative items and, particularly we use the classification regarding variable versus fixed costs to start talking about the cost-volume profit analysis, whose applications are the following: 1. What a company doesn’t want to target, bur wants to know in order to be on the safe side is the quantity of break-even or the sales of break-even, which is the minimum requirement for a business to stay alive: – – There is a formula to determine the quantity of break-even or for the purposes of moving ahead, we may say that the formula is based on one very simple equation that we solve for time to time defining what is the unknown. The equation based on which we determine the pre-set formula is: and so, the profit can be itemized by using this classification of variable to fixed costs in this way. Just to show that the formula is derived from that, let’s suppose that the profit is equal to 0 and what we want to identify (unknown) is the quantity of break-even: if we solve the equation in this way, we would find that: 2. Maybe the company doesn’t want to just recover the fixed costs, but it has a target in terms of targeted income, and so this formula changes because of that in this way: so, in this case the unknown is still the quantity, but instead of putting profit equal to zero we put profit equal to the targeted income, so the formula will be: 3. This cost-volume-profit analysis can be used in other ways, such as simulation kind of what if analysis, in the sense that the equation is always the same but what changes is the unknown, that is no more the quantity. 4. The cost-volume-profit analysis can be used to determine the margin of safety, which means how above or how below is the company currently versus the quantity or the sales of break-even, so the idea is to determine how safe the company is in terms of reaching the break-even point or even exceeding the breakeven point. 5. The degree of operating leverage (DOL) indicates a level of operating risk, so it measures the percentage change in profit associated with a percentage change in volume or sales (it tells what is the change in profit given the fact that there has been a change in quantity or sales, which can be positive or negative), but the relative size of the increase of the profit depends heavily on the ratio of fixed to variable costs. COST-VOLUME-PROFIT ANALYSIS: KEY ASSUMPTIONS To simplify CVP calculations, managers typically adopt the following assumptions with respect to these factors: 1. Selling price is constant. The price of a product or service will not change as volume changes. 2. Costs are linear and can be accurately divided into variable and fixed components. The variable costs are constant per unit and the fixed costs are constant in total over the entire relevant range. 3. In multiproduct companies, the mix of products sold remains constant. BASICS OF COST-VOLUME-PROFIT ANALYSIS The contribution income statement is helpful to managers in judging the impact on profits of changes in selling price, cost, or volume. The emphasis is on cost behavior. – The Contribution Margin (CM) is the amount remaining from sales revenue after variable expenses have been deducted 8 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting | Martina Marazzi – The Contribution Margin is used first to cover fixed expenses; any remaining Contribution Margin contributes to net operating income THE CONTRIBUTION APPROACH Sales, variable expenses, and contribution margin can also be expressed on a per unit basis. The contribution margin per unit does not change but is constant since – – Price per unit is constant Variable costs per unit are constant so, even the contribution margin is constant, and this is an assumption that we take, but what changes is the total contribution margin since it depends on the volume (number of units). If Racing sells an additional bicycle, $200 additional CM will be generated to cover fixed expenses and profit. Each month, RBC must generate at least $80,000 in total contribution margin to break-even (which is the level of sales at which profit is zero). If RBC sells 400 units in a month, it will be operating at the break-even point. If RBC sells one more bike (401 bikes), net operating income will increase by $200, since any additional unit after the break-even is basically an addition to the end profit, and this is because with 400 bicycles the company has the break-even, while with 401 bicycles it adds incrementally the contribution margin to its profit. We do not need to prepare an income statement to estimate profits at a particular sales volume. Simply multiply the number of units sold above break-even by the contribution margin per unit. If Racing sells 430 bikes, its net operating income will be $6,000 (30 units x $200 per unit) CVP RELATIONSHIPS IN EQUATION FORM The contribution format income statement can be expressed in the following equation: 9 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting | Martina Marazzi Example This equation can be used to show the profit RBC earns if it sells 401. Notice, the answer of $200 mirrors our earlier solution. CVP RELATIONSHIPS IN EQUATION FORM – DETAIL BREAKDOWN When a company has only one product, we can further refine this equation as shown on this slide: Example This equation can also be used to show the $200 profit RBC earns if it sells 401 bikes. CVP RELATIONSHIPS IN EQUATION FORM – USING UNIT CONTRIBUTION MARGIN It is often useful to express the simple profit equation in terms of the unit contribution margin (Unit CM) as follows: – – Example Learning Objective 2: Prepare and interpret a cost volume-profit (CVP) graph and a profit graph CVP RELATIONSHIPS IN GRAPHIC FORM 10 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting | Martina Marazzi The relationships among revenue, cost, profit, and volume can be expressed graphically by preparing a CVP graph. Racing Bicycle developed contribution margin income statements at 0, 200, 400, and 600 units sold. We will use this information to prepare the CVP graph. PREPARING THE CVP GRAPH 1. In a CVP graph, unit volume is usually represented on the horizontal (X) axis and dollars on the vertical (Y) axis 2. Draw a line parallel to the volume axis to represent total fixed expenses 3. Choose some sales volume, say 400 units, and plot the point representing total expenses (fixed and variable). Draw a line through the data point back to where the fixed expenses line intersects the dollar axis 4. Choose some sales volume, say 400 units, and plot the point representing total sales. Draw a line through the data point back to the point of origin PREPARING THE CVP GRAPH – SIMPLE FORM An even simpler form of the CVP graph is called the profit graph: Learning Objective 3: Use the contribution margin ratio (CM ratio) to compute changes in contribution margin and net operating income resulting from changes in sales volume CONTRIBUTION MARGIN RATIO (CM RATIO) AND THE VARIABLE EXPENSE RATIO The contribution margin as a percentage of sales is referred to as the contribution margin ratio (CM ratio). The ratio is computed as follows: For RBC, the contribution margin ratio is calculated as follows: For each $1.00 increase in sales results in a total contribution margin increase of 40%. The CM ratio can also be calculated by dividing the contribution margin per unit by the selling price per unit: For RBC, the contribution margin ratio is calculated as follows: 11 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting | Martina Marazzi The variable expenses as a percentage of sales is referred to as the variable expense ratio. This ratio is computer as follows: For RBC, the variable expense ratio is calculated as follows: Having defined the two terms, it bears emphasizing that the contribution margin ratio and the variable expense ratio can be mathematically related to one another: For RBC, the contribution margin ratio is calculated as follows: APPLICATIONS OF CONTRIBUTION RATIO If RBC increases sales from 400 to 500 bikes ($50,000), contribution margin will increase by $20,000 ($50,000 × 40%). Here is the proof: A $50,000 increase in sales revenue results in a $20,000 increase in CM ($50,000 × 40% = $20,000) APPLICATIONS OF CONTRIBUTION RATIO – INCREASE IN SALES VOLUME The relationship between profit and the CM ratio can be expressed using the following equation: If RBC increased its sales volume to 500 bikes, what would management expect profit or net operating income to be? Learning Objective 4: Show the effects on net operating income of changes in variable costs, fixed costs, selling price, and volume Example 1 What is the profit impact if Racing Bicycle can increase unit sales from 500 to 540 by increasing the monthly advertising budget by $10,000? Sales increased by $20,000, but net operating income decreased by $2,000. A shortcut solution using incremental analysis: 12 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting | Martina Marazzi Increase in CM (40 units x $200) Increase in advertising expenses Decrease in net operating income $ 8.000,00 $ 10.000,00 $ -2.000,00 Example 2 What is the profit impact if Racing Bicycle can use higher quality raw materials, thus increasing variable costs per unit by $10, to generate an increase in unit sales from 500 to 580? Sales increase by $40,000 and net operating income increases by $10,200. Example 3 What is the profit impact if RBC: 1. Cuts its selling price $20 per unit, 2. Increases its advertising budget by $15,000 per month, and 3. Increases sales from 500 to 650 units per month? Sales increase by $62,000, fixed costs increase by $15,000, and net operating income increases by $2,000. Example 4 What is the profit impact if RBC: 1. Pays a $15 sales commission per bike sold instead of paying salespersons flat salaries that currently total $6,000 per month, and 2. Increases unit sales from 500 to 575 bikes? Sales increase by $37,500, fixed expenses decrease by $6,000, and net operating income increases by $12,375. Example 5 If RBC has an opportunity to sell 150 bikes to a wholesaler without disturbing sales to other customers or fixed expenses, what price would it quote to the wholesaler if it wants to increase monthly profits by $3,000? $ 3,000 ÷ 150 bikes Variable cost per bike Selling price required $ 20,00 $ 300,00 $ 320,00 per bike 150 bikes × $320 per bike per bike Total variable costs per bike Increase in net operating income $ 48.000,00 $ 45.000,00 $ 3.000,00 Learning Objective 5: Determine the break-even point BREAK-EVEN ANALYSIS The equation and formula methods can be used to determine the unit sales and dollar sales needed to achieve a target profit of zero. Let’s use the RBC information to complete the break-even analysis. The equation method relies on the basic profit equation introduced earlier in the chapter. Because Racing Bicycle has only one product, we’ll use the contribution margin form of this equation to perform the break-even calculations. We calculate break-even by solving the equation below. In a single product situation, the equation method for computer the unit sales at break-even is: 13 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting | Martina Marazzi BREAK-EVEN ANALYSIS: FORMULA METHOD The formula method is a shortcut version of the equation method. It centres on the idea discussed earlier in the chapter that each unit sold provides a certain amount of contribution margin that goes toward covering fixed expenses. BREAK-EVEN ANALYSIS: DOLLAR SALES Suppose Racing Bicycle wants to compute the sales dollars required to break-even (earn a target profit of $0). Let’s use the equation method and the formula method to solve this problem. The equation method is shown on this slide: Learning Objective 6: Determine the level of sales needed to achieve a desired target profit TARGET PROFIT ANALYSIS In target profit analysis, we estimate what sales volume is needed to achieve a specific target profit. We can also compute the number of units that must be sold to attain a target profit using either: Equation Method or Formula Method TARGET PROFIT ANALYSIS – EQUATION METHOD Our goal is to solve for the unknown “Q,” which represents the quantity of units that must be sold to attain the target profit. Suppose RBC’s management wants to know the how many bikes must be sold to earn a target profit of $100,000. TARGET PROFIT ANALYSIS – FORMULA METHOD The formula method uses the following equation: Suppose RBC wants to know how many bikes must be sold to earn a profit of $100,000. TARGET PROFIT ANALYSIS – FORMULA METHOD AND EQUATION METHOD SALES DOLLARS We can also compute the target profit in terms of sales dollars using either the equation method or the formula method. Suppose RBC’s management wants to know the sales volume that must be generated to earn a target profit of $100,000. Equation Method 14 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting | Martina Marazzi Formula Method Learning Objective 7: Compute the margin of safety and explain its significance THE MARGIN OF SAFETY IN DOLLARS The margin of safety is the excess of budgeted or actual sales dollars over the break-even volume of sales dollars. It is the amount by which sales can drop before losses are incurred. The higher the margin of safety, the lower the risk of not breaking even and incurring a loss. Let’s look at RBC and determine the margin of safety: If we assume that RBC has actual sales of $250,000, given that we have already determined the break-even sales to be $200,000, the margin of safety is $50,000 as shown. THE MARGIN OF SAFETY PERCENTAGE RBC’s margin of safety can be expressed as 20% of sales ($50,000 ÷ $250,000). THE MARGIN OF SAFETY IN UNITS The margin of safety can be expressed in terms of the number of units sold. The margin of safety at RBC is $50,000, and each bike sells for $500; hence, RBC’s margin of safety is 100 bikes. COST STRUCTURE AND PROFIT STABILITY Cost structure refers to the relative proportion of fixed and variable costs in an organization. Managers often have some latitude in determining their organization’s cost structure. There are advantages and disadvantages to high fixed cost (or low variable cost) and low fixed cost (or high variable cost) structures. – – An advantage of a high fixed cost structure is that income will be higher in good years compared to companies with lower proportion of fixed costs A disadvantage of a high fixed cost structure is that income will be lower in bad years compared to companies with lower proportion of fixed costs Companies with low fixed cost structures enjoy greater stability in income across good and bad years. Leaning Objective 8: Compute the degree of operating leverage at a particular level of sales and explain how it can be used to predict changes in net operating income OPERATING LEVERAGE Operating leverage is a measure of how sensitive net operating income is to percentage changes in sales. It is a measure, at any given level of sales, of how a percentage change in sales volume will affect profits. To illustrate, let’s revisit the contribution income statement for RBC. OPERATING LEVERAGE – CHANGE IN PROFIT With an operating leverage of 5, if RBC increases its sales by 10%, net operating income would increase by 50%. Percent increase in sales Degree of operating leverage $ 10% 5,00 15 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting | Martina Marazzi Percent increase in profits 50% STRUCTURING SALES COMMISSIONS Companies generally compensate salespeople by paying them either a commission based on sales or a salary plus a sales commission. Commissions based on sales dollars can lead to lower profits in a company. Example Pipeline Unlimited produces two types of surfboards, the XR7 and the Turbo. The XR7 sells for $100 and generates a contribution margin per unit of $25. The Turbo sells for $150 and earns a contribution margin per unit of $18. The sales force at Pipeline Unlimited is compensated based on sales commissions. If you were on the sales force at Pipeline, you would push hard to sell the Turbo even though the XR7 earns a higher contribution margin per unit. To eliminate this type of conflict, commissions can be based on contribution margin rather than on selling price alone. Learning Objective 9: Compute the break-even point for a multiproduct company and explain the effects of shifts in the sales mix on contribution margin and the break-even point So far, we operated with companies selling just one product (we never had an example of a company selling two different products), but this is not possible. Usually, even in the case of small companies, the products sold are several. – – – Sales mix is the relative proportion in which a company’s products are sold Different products have different selling prices, cost structures, and contribution margins When a company sells more than one product, breakeven analysis becomes more complex Let’s assume RBC sells bikes and carts and that the sales mix between the two products remains the same. Bikes comprise 45% of RBC’s total sales revenue and the carts comprise the remaining 55%. RBC provides the following information: JOB-ORDER COSTING: CALCULATING UNIT PRODUCT COSTS Now, we are approaching the cost classification that distinguish between product cost and period cost since we start to think about how to cost a product and the next problem is understanding how to assign this cost to the product. We start to consider a product that is very visible, and a product that is very visible is a job order: now we need to understand how to compute its cost. JOB-ORDER COSTING Job-order costing systems are used when: 1. Many different products are produced each period 2. Products are manufactured to order 3. The unique nature of each order requires tracing or allocating costs to each job and maintaining cost records for each job Examples of companies that would use job-order costing include: 16 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting | Martina Marazzi 1. Boeing (aircraft manufacturing) 2. Bechtel International (large scale construction) 3. Walt Disney Studios (movie production) The difference between product and period costs is that product costs are typically related to the manufacturing, while period costs are typically non-manufacturing (beyond the factory = service), but product costs have a very specific and distinctive feature, which that they are inventoriable, so they can be capitalised when the product that is manufactured is not sold and therefore this product cost becomes the value of the inventory, while period costs cannot be capitalized, and so they would go straight to the P/L. The fist two costs that we associate easily with the product (the job order) are direct material and direct labor, but the main problem is related to the association of the manufacturing overhead to each individual job. These manufacturing overheads include indirect materials and indirect labors, which, as the word indirect says, cannot be traced directly (not observable), so there are a bunch of other items that needs to be assigned to each individual job and we need to find a way to allocate these manufacturing overheads to each individual job. Learning Objective 1: Compute a predetermined overhead rate WHY USE AN ALLOCATION BASE? An allocation base, such as direct labor hours, direct labor dollars, or machine hours, is used to assign manufacturing overhead to individual jobs. We use an allocation base because: a. It is impossible or difficult to trace overhead costs to particular jobs b. Manufacturing overhead consists of many different items ranging from the grease used in machines to the production manager’s salary c. Many types of manufacturing overhead costs are fixed even though output fluctuates during the period In order to be fair and associate a fair amount of overhead to the job, what we have to do is to aggregate and estimate all the manufacturing overhead over a significant amount of time (1 year) and then we predetermine the overhead rate. This costing needs to be determined when the job is completed because most of the times the cost is used to determine the selling price, so the company needs to have all the elements. MANUFACTURING OVERHEAD APPLICATION The predetermined overhead rate (POHR) used to apply overhead to jobs is determined before the period begins: Ideally, the allocation base is a cost driver (cost driver means the items that makes or influences the total cost, what is driving the cost) that causes overhead, and we will see that in some cases the cost changes because of the volume, while in other cases the cost changes because of other reasons that are not volume related. THE NEED FOR A PREDETERMINE OVERHEAD RATE Predetermined overhead rates that rely upon estimated data are often used because: 1. Actual overhead for the period is not known until the end of the period, thus inhibiting the ability to estimate job costs during the period 2. Actual overhead costs can fluctuate seasonally, thus misleading decision makers COMPUTING PREDETERMINED OVERHEAD RATES The predetermined overhead rate is computed before the period begins using a four-step process: 1. Estimate the total amount of the allocation base (the denominator) that will be required for next period’s estimated level of production. 2. Estimate the total fixed manufacturing overhead cost for the coming period and the variable manufacturing overhead cost per unit of the allocation base. 3. Use the following equation to estimate the total amount of manufacturing overhead: 17 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting | Martina Marazzi Where: – Y = The estimated total manufacturing overhead cost – a = The estimated total fixed manufacturing overhead cost – b = The estimated variable manufacturing overhead cost per unit of the allocation base – X = The estimated total amount of the allocation base 4. Compute the predetermined overhead rate (by dividing the total amount of overhead by the number of estimated hours) The predetermined overhead rate is complicated because, after estimating the total amount of overhead and the total amount of hours used as allocation based, the manufacturing overhead are fixed and variable. Consumption and electricity bills are variable overhead, in fact they are overhead, but they depend on the volume of activity, while depreciation of the facilities is still an overhead, but fixed. Learning Objective 2: Apply overhead cost to jobs using a predetermined overhead rate OVERHEAD APPLICATION RATE PearCo estimates that it will require 160,000 direct labor-hours to meet the coming period’s estimated production level. In addition, the company estimates total fixed manufacturing overhead at $200,000, and variable manufacturing overhead costs of $2.75 per direct labor hour. Y = a + bX Y = $200,000 + ($2.75 per direct labor-hour × 160,000 direct labor hours) Y = $200,000 + $440,000 Y = $640,000 RECORDING MANUFACTURING OVERHEAD We use this type of information to cost the jobs, which means that the job has used 8 hours, so we multiply it by the rate and there we got the information. This piece of information is available at the time when the job is completed, so the company doesn’t need to wait until the end of the year to know how much the actual manufacturing overhead and actual direct labor hours used are, and so the company is able to determine the price for the customers. Learning Objective 3: Compute the total cost and the unit product cost of a job using a plantwide predetermined overhead rate CALCULATING TOTAL COST OF JOB AND UNIT PRODUCT COST JOB-ORDER COSTING – A MANAGERIAL PERSPECTIVE Inaccurately assigning manufacturing costs to jobs adversely influences planning and decisions made by managers. 1. Job-order costing systems can accurately trace direct materials and direct labor costs to jobs 2. Job-order costing systems often fail to accurately allocate the manufacturing overhead costs used during the production their respective jobs Choosing an Allocation Base 18 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting | Martina Marazzi Job-order costing systems often use allocation bases that do not reflect how jobs actually use overhead resources. The allocation base in the predetermined overhead rate must drive the overhead cost to improve job cost accuracy. A cost driver is a factor that causes overhead costs. Many companies use a single predetermined plantwide overhead rate to allocate all manufacturing overhead costs to jobs based on their usage of direct-labor hours. 1. It is often overly simplistic and incorrect to assume that direct-labor hours is a company’s only manufacturing overhead cost driver 2. If more than one overhead cost driver can be identified, job cost accuracy is improved by using multiple predetermined overhead rates Learning Objective 4: Compute the total cost and the unit product cost of a job using multiple predetermined overhead rates INFORMATION TO CALCULATE MULTIPLE PREDETERMINED OVERHEAD RATES Dickson Company has two production departments, Milling and Assembly. The company uses a job-order costing system and computes a predetermined overhead rate in each production department. The predetermined overhead rate in the Milling Department is based on machine-hours and in the Assembly Department it is based on direct labor-hours. The company uses cost-plus pricing (and a markup percentage of 75% of total manufacturing cost) to establish selling prices for all of its jobs. At the beginning of the year, the company made the following estimates: STEP 1 – CALCULATE THE PREDETERMINED OVERHEAD COST FOR EACH DEPARTMENT During the current month the company started and completed Job 407. It wants to use its predetermined departmental overhead cost and rate for the Milling and Assembly Departments. STEP 2 – CALCULATE THE PREDETERMINED OVERHEAD RATE FOR EACH DEPARTMENT During the current month the company started and completed Job 407. It wants to use its predetermined departmental overhead cost and rate for the Milling and Assembly Departments. STEP 3 – CALCULATE THE AMOUNT OF OVERHEAD APPLIED FROM BOTH DEPARTMENTS TO A JOB Use the POR calculated on the previous slide to determine the overhead applied from both departments to Job 407: STEP 4 – CALCULATE THE TOTAL JOB COST FOR JOB 407 We can use the information given to calculate the amount of the total cost of Job 407. Here is the calculation: 19 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting | Martina Marazzi STEP 5 – CALCULATE THE SELLING PRICE FOR JOB 407 The selling price of Job 407 assuming a 75% markup: It is important to emphasize that using a departmental approach to overhead application results in a different selling price for Job 407 than would have been derived using a Plantwide overhead rate based on either direct labor-hours or machine-hours. The appeal of using predetermined departmental overhead rates is that they presumably provide a more accurate accounting of the costs caused by jobs, which in turn, should enhance management planning and decision making. MULTIPLE PREDETERMINED OVERHEAD RATES – AN ACTIVITY-BASED APPROACH When a company creates overhead rates based on the activities that it performs, it is employing an approach called activity-based costing. Activity-based costing is an alternative approach to developing multiple predetermined overhead rates. Managers use activity-based costing systems to more accurately measure the demands that jobs, products, customers, and other cost objects make on overhead resources. Learning Objective 5: Use job cost sheets to calculate ending inventories and cost of goods sold JOB COST SHEETS Job-order costing systems are often used to create a balance sheet and income statement for external parties. All of a company’s job cost sheets collectively form a subsidiary ledger. The job costs sheets provide an underlying set of financial records that explain what specific jobs comprise the amounts reported in Work-in-Process and Finished Goods on the Balance Sheet. The job costs sheets provide an underlying set of financial records that explain what specific jobs comprise the amounts reported in Cost of Goods Sold on the income statement. JOB-ORDER COSTING FOR FINANCIAL STATEMENTS TO EXTERNAL PARTIES The amount of overhead applied to all jobs during a period will differ from the actual amount of overhead costs incurred during the period. 1. When a company applies less overhead to production than it actually incurs, it creates what is known as underapplied overhead 2. When it applies more overhead to production than it actually incurs, it results in overapplied overhead FINANCIAL ADJUST FOR OVERHEAD APPLIED The cost of goods sold reported on a company’s Income Statement must be adjusted to reflect underapplied or overapplied overhead. 1. The adjustment for underapplied overhead increases cost of goods sold and decreases net operating income 2. The adjustment for overapplied overhead decreases cost of goods sold and increases net operating income JOB-ORDER COSTING IN SERVICE COMPANIES Although our attention has focused on manufacturing applications, it bears re-emphasizing that job-order costing is also used in service industries. Job-order costing is also used in many different types of service companies. For example, law firms, accounting firms, and medical treatment. QUICK RECAP 20 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting | Martina Marazzi In order to cost a job, we need to trace costs: some are more directly traceable, like labor and material, while others are indirectly traceable, like all the manufacturing overhead, which includes fixed manufacturing overhead and variable manufacturing overhead. In order to trace these manufacturing overhead we need to determine the so called predetermined overhead rate, which is predetermined because we compute it at the beginning of every period because the accrual of the manufacturing overhead is not synchronized with the manufacturing of the job, so because we lack this synchronization, we extend our time horizon to 1 year and at the beginning of the period we estimate both component of the predetermined overhead rate, that is the numerator (total manufacturing overhead) and the denominator (allocation base based on which we would like to allocate the overhead). So, we estimate and then we start producing, and from time to time we complete the jobs; every time we complete the job we apply the overhead, based on the predetermined allocation rate multiplied the allocation base (actual). So, these allocated applied overhead to each job, and then cumulatively in the whole year, it’s a combination of a predetermined rate, which is established at the beginning of the period, and an actual utilization of the allocation base as we go. What can happen at the end of the period? At the end of the period, we have two numbers: an applied overhead (all the applied overhead to each individual job) and the actual overhead. So, we have to gather, measure and record which is the actual amount of overhead, so basically whatever is recorded in the transaction we have seen in financial accounting. These values equate or not? It depends: if the two are the same it means that the cost of product (which is a product cost, so can be inventoried) that is associated to the finished good inventory is corrected estimated and computed, but it can happen that we apply too much (applied manufacturing overhead > actual manufacturing overhead) or it can happen that we apply too little (applied manufacturing overhead < actual manufacturing overhead). The problem is the following: – – When we look at the cost of product if we have an over application of manufacturing overhead, the cost of product is overstated When we look at the cost of product if we have an under application of manufacturing overhead, the cost of product is understated Since normally this account needs to be cleared (set to zero) for the following accounting period, what can happen that in order to close it we should write off whatever remains in one side or in the other side and adjust it in the cost of goods sold (because sooner or later these finished goods will be sold), in order to take into account that the cost of product may be underestimated or overestimated. VARIABLE COSTING AND SEGMENT REPORTING: TOOLS FOR MANAGEMENT Learning Objective 1: Explain how variable costing differs from absorption costing and compute unit product costs under each method THREE SIMPLIFYING ASSUMPTIONS 1. This chapter uses actual costing rather than the normal costing approach that was used in the job order costing chapters. 2. This chapter always uses the actual number of units produced as the allocation base for assigning actual fixed manufacturing overhead costs to products. 21 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting | Martina Marazzi 3. This chapter always assumes that the variable manufacturing costs per unit and the total fixed manufacturing overhead cost per period remain constant. Variable costing has something to do with the cost classification regarding variable to fixed costs and it means the utilization of only variable costs to compute the cost of product. Absorption costing, which is the contrary of variable costing, means costing the product by including both the fixed component and the variable component. So, we are computing the cost of product and we apply the cost classification variable versus fixed: – In one case, variable costing, we associate to the cost of product only variable costs (it doesn’t matter whether they are direct or indirect) – In the other case, absorption costing, we associate to the cost of product costs that are both variable and fixed OVERVIEW OF VARIABLE AND ABSORPTION COSTING In the case of variable costing, only the direct and indirect, as long as they are variable costs, are product costs, while the rest is period costs. In the case of absorption costing, not only direct and indirect variable costs, but also fixed manufacturing overhead is product costs, while the rest is period costs. Therefore, the difference between variable costing and absorption costing is this component of fixed manufacturing overhead, that in one case are cost of product and in the other case are costs of period. Just to remember, in the accounting flow product costs differ from period costs because product costs can be associated to the inventory and if sold, they will impact on the cost of goods sold, but they are capitalized in inventory. This little difference can create differences in the value of income under certain conditions. UNIT COST COMPUTATIONS Harvey Company produces a single product with the following information available: Unit product cost is determined as follows: Absorption Costing Variable costing 22 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting | Martina Marazzi Direct materials, direct labor, and variable mfg. overhead Fixed mfg. Overhead ($150,000 ÷ 25,000 units) Unit product cost $ 10,00 $ 10,00 $ $ 6,00 16,00 $ $ 10,00 Under absorption costing, all production costs, variable and fixed, are included when determining unit product cost. Under variable costing, only the variable production costs are included in product costs. Learning Objective 2: Prepare income statements using both variable and absorption costing VARIABLE AND ABSORPTION COSTING INCOME STATEMENTS – Let’s assume the following additional information for Harvey Company. – 20,000 units were sold during the year at a price of $30 each. There is no beginning inventory. Now, let’s compute net operating income using both absorption and variable costing. VARIABLE COSTING CONTRIBUTION FORMAT INCOME STATEMENT Variable manufacturing Variable manufacturing costs only costs only ABSORPTION COSTING INCOME STATEMENT Unit product cost Fixed manufacturing overhead deferred in inventory is 5,000 units × $6 = $30,000. Learning Objective 3: Reconcile variable costing and absorption costing net operating incomes and explain why the two amounts differ COMPARING THE TWO METHODS 23 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting | Martina Marazzi We can reconcile the difference between absorption and variable income as follows: Variable costing net operating income Add: Fixed mfg. Overhead costs deferred in inventory (5,000 units x $6 per unit) Absorption costing net operating income $ 90.000 $ $ 30.000 120.000 EXTENDED COMPARISONS OF INCOME DATA HARVEY COMPANY – YEAR TWO UNIT COST COMPUTATIONS Absorption Costing Direct materials, direct labor, and variable mfg. overhead Fixed mfg. Overhead ($150,000 ÷ 25,000 units) Unit product cost Variable costing $ 10,00 $ 10,00 $ $ 6,00 16,00 $ $ 10,00 Since the variable costs per unit, total fixed costs, and the number of units produced remained unchanged, the unit cost computations also remain unchanged. VARIABLE COSTING Variable manufacturing costs only All fixed manufacturing overhead is expensed 24 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting | Martina Marazzi ABSORPTION COSTING Unit product cost Fixed manufacturing overhead released from inventory is 5,000 units × $6 = $30,000. RECONCILING THE DIFFERENCE We can reconcile the difference between absorption and variable income as follows: Variable costing net operating income $ Add: Fixed mfg. Overhead costs deferred in inventory (5,000 units x $6 per unit) Absorption costing net operating income 260.000 $ $ 30.000 230.000 SUMMARY OF KEY INSIGHTS Relation between production and sales Units produced = Units sold Units produced > Units sold Units produced < Units sold ENABLING CVP ANALYSIS Effect on inventory No change in inventory Inventory increases Inventory decreases Relation between production and sales Absorption = Variable Absorption > Variable Absorption < Variable 25 Downloaded by Chiara Davoli ([email protected]) lOMoARcPSD|11350337 Financial Statement Analysis and Managerial Accounting | Martina Marazzi Variable costing categorizes costs as variable and fixed, so it is much easier to use this income statement format for CVP analysis (to have an highlight of the contribution margin, which is the change of the overall income due to in the volume of the overall activity). Because absorption costing assigns fixed manufacturing overhead costs to units produced ($6 per unit for Harvey Company), a portion of fixed manufacturing overhead resides in inventory when units remain unsold. The potential result is positive operating income when the number of units sold is less than the breakeven point. Explaining Changes in Net Operating Income Variable costing income is only affected by changes in unit sales; it is not affected by the number of units produced. As a general rule, when sales go up, net operating income goes up, and vice versa. Absorption costing income is influenced by changes in unit sales and units of production; net operating income can be increased simply by producing more units even if those units are not sold. By using absorption costing we would not be able to run the break-even analysis or the cost-volume-profit analysis because we have a distortion of the fixed manufacturing overhead, which under absorption costing are considered variable, but are not variable, they are in fact fixed. SUPPORTING DECISION MAKING Variable costing correctly identifies the additional variable costs incurred to make one more unit ($10 per unit for Harvey Company). It also emphasizes the impa